FY Income Equity-2021 vs. R1000V
Market Observations & Portfolio Commentary
2021 Market Update
US stocks posted another year of double-digit returns and new all time highs. A strong rebound in the US economy in 2021 and historically strong earnings momentum offset concerns over COVID-19 variants, elevated inflation and pandemic related supply chain disruptions. On balance, it was a micro-driven year, and the market rewarded profitability across sectors, size and styles. Large Cap stocks led Smaller Caps. Stylistically, Growth outperformed Value in the Large Cap space, while Value significantly led Growth among Small and Mid Caps. Defensive shares outperformed the more cyclical shares, but the difference in returns was more evident in the Small Cap space. With regard to factors driving performance, most categories had a positive influence on returns, but the results were mixed within Growth, Volatility, and Momentum factors.
Key Performance Takeaways for the Year
- The London Company Income Equity portfolio returned 26.4% gross (25.9% net) for the year vs. a 25.2% increase in the Russell 1000 Value. Outperformance was driven by strong stock selection, partially offset by negative sector exposure.
- We are bottom-up stock pickers, but sector exposures influenced relative performance as follows:
- What Helped: Underweight Utilities & Comm. Services (two weaker performing sectors)
- What Hurt: Overweight Info. Technology (a weaker performing sector) & underweight Financials (a better performing sector)
- For the year, absolute and relative performance were quite strong and exceeded our upside capture expectations. Solid stock selection and a rebound in Quality factors helped us overcome the headwind of being underweight to Banks & Energy—two of the best performing groups in the Value index. For a year of such robust returns with limited drawdowns, we were pleased with our absolute and relative results.
Top 3 Contributors to Relative Performance
- Lowe’s (LOW) – LOW benefited from strong DIY foot traffic, Pro projects, and home improvement trends in 2021. The outlook and fundamentals remain in good shape. We expect LOW will continue to close the gap on Home Depot’s margins and drive meaningful, sustainable shareholder value.
- Microsoft (MSFT) – MSFT posted a strong return for 2021. The cloud business remains very strong in terms of financial impact and visibility. While the equity is arguably expensive on near term earnings, MSFT has one of the best growth profiles in its sector and should be able to sustain double-digit growth for several years with the backing of a first-class management team and fortress balance sheet.
- Paychex (PAYX) – PAYX outperformed during 2021 as it benefitted from a recovery in the labor market and strong internal execution. PAYX is seeing record high client retention and better pricing power, in addition to higher win rates in the market for new business.
Top 3 Detractors from Relative Performance
- Nintendo (NTDOY) – NTDOY underperformed the broader market in 2021 reflecting concerns about the long-term stability of both operating margins and cash flow. We note that EBIT margins are near all-time highs today due to the success of the Switch, and some decline is likely in the future. While margins may decline, we believe that profitability will remain strong longer term with less volatility in cash flow due to greater digital sales, the ability to monetize its intellectual property over time, and longer hardware cycles. Valuation appears very attractive at 7.7x EV/EBITDA, and we believe NTDOY trades at a steep discount to our conservative estimate of intrinsic value.
- Merck (MRK) – MRK posted slightly positive returns for 2021, but lagged the broader market. MRK experienced weak sales due to the pandemic (the majority of MRK’s portfolio is physician administered drugs). Investors have also focused on Keytruda concentration risk and a thin late-stage pipeline. We remain attracted to MRK’s strong bullpen of drugs and vaccines, its level of R&D spending, its substantial margins and consistent cash flow, and plus its healthy dividend yield.
- Verizon (VZ) – VZ was down in 2021 despite a strong return for the market. VZ met or exceeded quarterly earnings guidance this year, but concerns about the competitive environment and the rising cost of spectrum created concerns about both lower margins and returns on capital in the future. Longer term, we believe the current intense competition will revert to a rationale oligopoly, and the expanded spectrum could lead to even better network quality, new customers, and reduced customer churn. We believe the quality, size and scale of VZ’s network are durable competitive advantages. The attractive valuation, near 5% dividend yield and limited downside (quality of the network, stability of cash flows, valuation) make it a solid holding.
Portfolio Characteristics & Positioning
We believe the Income Equity strategy is well positioned based on the strength of the companies owned and the overall quality characteristics of the portfolio—measured by sustainably high returns on capital and modest leverage. While the portfolio currently trades at a premium to the Value index, we believe this is justified as companies in the Value indexes have lower returns on capital and higher debt levels.
We remain positive regarding the economic outlook. As we enter 2022, we expect solid, but moderating economic growth. COVID remains a risk; but fortunately, the latest Omicron wave appears to be having less of an impact on the broader economy than prior variants. Meanwhile, inflation is still elevated, and the Fed is set to reverse accommodative monetary policy, which could further weigh on economic growth. In terms of the equity market, we recognize valuations are on the rich side, while interest rates will likely remain low vs. history. The Fed is expected to begin increasing the funds rate later in 2022, but the increases will likely be in small increments. At current valuations along with various short term risks to the economic outlook (rising inflation, higher interest rates, potential tax increases), we expect greater volatility and possibly more muted returns in the near term. Given this backdrop, we believe a long term-approach, with a focus on Quality factors that help dampen volatility, will reward investors.
As of 12/31/2021
Inception date: 12/31/1999. Past performance should not be taken as a guarantee of future results.
The London Company’s performances are size weighted and annualized based on calculations for the period ending December 31, 2021. The characteristics discussed herein relate to a representative account, and not every client’s account will have these exact characteristics. As London manages its client portfolios according to each client’s specific investment needs and circumstances, London cannot affirm that the characteristics of the account shown are similar to all accounts participating in the strategy. This is due in part to the timing of trades by the Advisor, market conditions, cash availability, and the timing of client deposits and withdrawals. Therefore, prospective clients should not assume that similar performance results to those shown would have been achieved for their accounts had they been invested in the strategy during the period. None of the information contained herein should be construed as an offer to buy or sell securities, or as investment recommendations. An investment in a London Company strategy is subject to risks, including the loss of principal.
Definition of Firm: The London Company of Virginia is a registered investment advisor. Registration does not imply a certain level of skill or training. More information about the advisor, including full descriptions of its investment strategies, fees and objectives, can be found in the firm’s Form ADV Part 2, which is available upon request by calling 804.775.0317 or visiting www.TLCadvisory.com. The London Company claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Please visit www.TLCadvisory.com or contact us at 804.775.0317 to request a complete list and description of The London Company’s composites and/or a presentation that adheres to the (GIPS®) standards.
Composite Creation/Inception Date: December 31, 1999
Composite Definition: The Income Equity strategy invests mainly in common equities with a focus on higher overall dividend yield orientation, which may be supplemented with primarily investment grade, preferred equities. This strategy has a more conservative orientation, with a focus on capital preservation, income and growth, in order to provide greater yield and downside protection relative to our Large and Mid Cap strategies. Our Income Equity strategy is designed to generate above-average, absolute returns over full market cycles. Accounts in this product composite are fully discretionary taxable and tax-exempt portfolios with no minimum dollar amount of assets. The product is measured against the Russell 1000 Value Index and has a creation and inception date of December 31, 1999. There is no use of leverage, derivatives or short positions. All actual fee-paying discretionary portfolios are included in one or more composites that have been managed for a full calendar quarter with limited restrictions and similar objectives. Composite may include accounts under dual contract.
Benchmark Description: The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower expected growth values. Benchmark returns are not covered by the report of independent verifiers.
Performance and Fees: Gross of fee returns are calculated gross of management and custodian fees and net of transaction costs. Net of fee returns are calculated net of actual management fees and transaction costs and gross of custodian and other fees. Returns may be net of miscellaneous fund expenses. The gross figures do not reflect the deduction of investment advisory fees. For example, an account that earned 15% per year for 10 years would have an accumulated return of 305% before fees and 270% after fees, assuming a 1% fee. Returns are calculated and stated in U.S. dollars. Returns are calculated gross of withholding taxes on foreign dividends and interest. Dividends are reinvested. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request.
Past performance should not be taken as a guarantee of future results. The report is for informational purposes only. Data, while obtained from sources we believe to be reliable, cannot be guaranteed and all statistics are subject to change. The statements contained herein are solely based upon the opinions of The London Company and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur. Information was obtained from third-party sources, which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell any specific securities and should not be considered investment advice of any kind. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor.